Speech
The Challenge of Central Clearing in OTC Derivatives Markets

Good morning, and thank you to ISDA for the opportunity to speak here today.

This conference is taking place at an interesting and challenging time for the
global financial system. Obviously a good deal of attention right now is focused
on Europe, particularly on the problem of sovereign debt sustainability and
its interaction with the condition of the European banking system. This is
a source of significant uncertainty for the rest of the world. Policymakers
are working hard to find solutions that will rebuild confidence, but the situation
is still fluid and it remains an area that will need to be closely watched.

In Australia meanwhile the financial system is continuing to perform relatively
well. The broad outlines of that story are, I think, well known. During the
GFC Australia avoided a recession and a banking crisis. Our banks are profitable
and well capitalised, and their overall asset quality remains good.

We can't of course expect the Australian system to be entirely immune from
the unfolding events in Europe, but a couple of points are worth emphasising.
The first is that the Australian banks have only limited direct exposures to
sovereign debt in the countries that are most at risk. So potential effects
on Australian banks' overall asset quality are not an issue. The second
point is that, since the height of the GFC, the Australian banks have done
a lot to strengthen their funding positions. They have increased their use
of domestic deposits as a funding source, lengthened the average term of their
wholesale funding, and correspondingly reduced their reliance on short-term
wholesale debt. These things will help to make them more resilient to the uncertainties
that are now affecting international credit markets.

As important as these current challenges are, financial regulators around the
world have been focusing not just on those, but also on longer-term regulatory
reforms. The reform effort is proceeding on a number of fronts, aimed at building
more robust financial systems for the longer term and thereby reducing the
risk of future crises. Many of these efforts are being coordinated internationally
through the G20 process, through the Financial Stability Board, and through
standard-setting bodies like the Basel Committee. In all of these bodies Australia
is actively represented.

In broad terms, the various reforms draw on the lessons that emerged from the
GFC, and they seek to remedy the weaknesses that became apparent during that
period. Hence, among other things, there is a significant effort through the
Basel process to increase the amount and quality of capital in the global banking
system, and to strengthen liquidity management by banks. Although, as I said,
we didn't have a banking crisis here during the GFC period, the Australian
regulators recognise the importance of improving standards, and we are working
on implementation of the various international initiatives in all these areas,
and others.

One particular piece of the picture that has absorbed a lot of our attention
at the Reserve Bank has been the work on financial market infrastructure, particularly
in relation to OTC derivatives clearing. I know this is very relevant to ISDA
members here today, and it's on this topic that I want to focus my main
remarks.

At the Pittsburgh Summit in September 2009, G20 leaders agreed, among other
things, to a common commitment to central clearing in key derivatives markets.
The commitment states that ‘all standardised OTC derivative contracts
should be traded on exchanges or electronic trading platforms, where appropriate,
and cleared through central counterparties by end-2012 at the latest’.
Australia was part of that agreement, and the Australian regulatory agencies,
like those in other G20 jurisdictions, are working through the issues associated
with its implementation.

In focusing on that today, I want to look at three questions:

why is there a general case for promoting central clearing?

what are the complexities involved?; and

where does the process stand in Australia?

First, why central clearing?

The general case for promoting central clearing in derivatives markets is based
on the aim of reducing systemic risk by managing interconnectedness. In markets
without central clearing, counterparty exposures build up bilaterally and,
in certain kinds of products, they can accumulate to very large notional amounts
over time. In many cases this might not be a problem, but where the interconnections
are extensive enough they can be a source of systemic risk. The risks from
those exposures might be managed well by individual institutions, but an institution
can't be sure that its dealings with others don't expose it to a lower
standard of risk control practiced by a counterparty, or anyone else in the
market that is linked through bilateral trades.

The clearing process, by novating positions to a central counterparty (CCP),
allows risks to be centrally managed to a standard acceptable to the market
and its regulators. Moreover, with legally enforceable multilateral netting,
gross exposures can be drastically reduced. As long as the CCP is itself robust,
the effect should be to reduce the scope for contagion and thereby limit the
impact on the market if one or more of the participants fail. The experience
with resolving the Lehman failure in 2008 testifies to the effectiveness of
this mechanism in a crisis. We might also expect that confidence in this mechanism
will help to underpin market liquidity during periods of financial stress.

All of this presupposes that the CCP is itself robust. Of course, CCPs themselves
have a strong incentive to control their risks, since they are after all in
the risk-reduction business. But it also points to the need for appropriate
regulatory standards to ensure that the risk controls in a CCP are commensurate
with its significance for the wider system.

Subject to that proviso, central clearing reduces aggregate counterparty risk
by replacing a web of bilateral exposures with a set of potentially much smaller
net exposures of each participant to a CCP with robust risk management. Individual
participants benefit from the reduction in risk but, importantly, so does the
stability of the system as a whole. In a nutshell, that is the basic case for
promoting central clearing as a policy objective in systemically important
derivatives markets.

Which brings me to my second question: what about the complexities?

When talking about these things in the abstract, it's easy to talk as though
a central counterparty is truly ‘central’. But in fact, as we all
know, it's not that simple. There is a huge array of markets in financial
instruments around the world and there are multiple CCPs for different instruments.
Some instruments are centrally cleared already, many are not. Not all instruments
are good candidates for central clearing, because they are not sufficiently
standardised and can't easily be made so.

It's also important to recognise that not all market participants are alike,
and not all can be expected to have direct access to the major CCPs even when
the new structures are fully in place. So the abstract model in which all participants
are connected to the central clearer won't be realised in practice.

For all these reasons, the optimal configuration of clearing arrangements in
the real world is far from obvious, and the way global markets will evolve
in response to a mandatory clearing environment across multiple jurisdictions
is hard to predict.

Another complication is the question of interconnectivity between clearers. A central clearer should, in some sense, be central.
In theory, netting benefits might be maximised by a single global CCP clearing
all the major instruments, with all active traders as members and all positions
included in the scope of multilateral netting. It's not clear that such
an outcome would be desirable even if it were possible. It would amount to
a massive concentration of risk at a single point and would give rise to complex
operational issues and questions of jurisdictional oversight.

But in any case, even if such an outcome were desirable, it won't be achieved.
The closest alternative might be to provide links that allow trades to be cleared
between participants in different CCPs. The question of how this might eventually
occur, or even of whether it is achievable at all, then becomes very important.
The weight of expert opinion is that the capacity to develop these links is
still a good way off. Links between CCPs also raise complex questions about
the transmission of risks from one CCP to another, and these will need to be
carefully studied.

For the foreseeable future, then, we will be in a world in which there is a
collection of CCPs, each of which has some source of competitive advantage
in its own location or its own area of specialisation. That advantage might
derive from historical legacy, or it might arise because the market that a
CCP is servicing has some sort of natural home in its own location. But these
markets will remain contestable and so the configuration of CCPs around the
world is likely to stay fluid, not least because the market will be rapidly
evolving in response to changing regulatory requirements.

It is in this very unpredictable environment that the domestic regulators are
considering the policy framework for central clearing in Australia.

Before I come to that, it's worth reviewing a few general facts about the
Australian OTC derivatives market. Its largest component, in terms of the amounts
outstanding, is the market for single-currency interest rate swaps –
the bulk of which are Australian dollar denominated. Australian banks (both
locally incorporated and foreign bank branches) have aggregate notional principal
amounts outstanding in this market of around $8
trillion.[2]

But banks operating in Australia are not the only entities to transact in this
market. From a jurisdictional point of view, we can (in principle) divide transactions
in the global market for Australian dollar derivatives into three types, namely
local-to-local, local-to-offshore, and entirely offshore. In fact the distinction
between a local and an offshore market participant is not entirely straightforward,
since many local participants are affiliated with offshore entities. That said,
the available data suggest that all three of those transaction types form a
significant share of the market. Most of the activity that involves the large
foreign banks as the two counterparties is already cleared through LCH SwapClear,
while the remainder of the market is currently uncleared.

It is of course misleading in another way to talk of these three market segments
as if they were separable. They are in fact closely interdependent, and liquidity
in each of the three parts benefits from the liquidity of the others. As a
related point, the Australian dollar market is itself interdependent with other
global markets, and specifically with derivatives markets in other currencies.

The regulatory agencies in Australia have indicated that they view the Australian
dollar interest rate swap market as being systemically important to the domestic
financial system. This reflects a number of considerations, including:

the size of the market

its fundamental role in hedging domestic interest rate risk, and

the long duration of counterparty risk in these instruments.

It is important to note, however, that although this market is large in relation
to the Australian financial system, it is not large in global terms.

The next largest OTC derivatives market in
Australia[3] is for FX-related
derivatives[4], in which the Australian banking system has a notional principal outstanding
of around $4 trillion. Other OTC markets, such as those for commodity derivatives,
are much smaller, though that is not to say that they don't have the potential
to grow over time.

For various reasons, international regulators are at this stage giving priority
in their regulatory strategies to single-currency interest rate swaps. Among
the reasons for that is that these instruments are often of relatively long
duration and have very large volumes outstanding, as well as the fact that
cross-currency instruments (the next biggest market) give rise to more complex
jurisdictional issues. In Australia, for similar reasons, any mandatory clearing
policy is likely to focus initially on the Australian-dollar interest rate
swaps market.

At the heart of the policy challenge are two inter-related questions: should
there be a mandatory clearing requirement in this market and, if so, should
it include a locational requirement, to the effect that trades be cleared by
a locally incorporated and locally regulated CCP? Since there is no domestic
CCP offering such a service currently, that would involve requiring industry
to come up with a solution that meets the regulatory objectives.

There are many factors that will have a bearing on this decision, but I think
they boil down to finding a balance between the two objectives of stability
and efficiency. The stability consideration comes from the point that I made
at the outset. The purpose of promoting central clearing is to reduce systemic
risk. CCPs reduce risk in one important respect, but they also concentrate
it in a specific location. Where a market is systemically important to the
Australian economy and financial system, this points to a case for the CCP
that clears it to be subject to appropriate safeguards that control the propagation
of risks to domestic participants. This might be best achieved where the CCP is locally incorporated and subject
to domestic regulation. At the least, it argues that the CCP should be subject
to safeguards that take into account its systemic significance for the Australian
market.

The second set of considerations are those related to efficiency. We have to
recognise that, even for instruments that are denominated solely in Australian
dollars, the market is a global one. The cost-effectiveness of a local CCP
will thus depend to a significant degree on global forces. I've tried to
highlight the uncertainties involved in predicting how the global market will
evolve. On that front, a number of submissions to our consultation process
have emphasised the risk of splitting the Australian dollar market if any local
clearing mandate turns out to be not sufficiently effective.

The cost-effectiveness and viability of a local CCP for this market will also
depend on aspects of the international regulatory environment that are not
yet determined, including the extent of eventual mutual recognition of CCPs
across borders by their respective regulators. We need to avoid an outcome
where internationally active banks find themselves subject to inconsistent
mandating requirements among the jurisdictions in which they operate. On that
issue, I note that the Financial Stability Board has recently begun discussions
on the challenges of mutual recognition, though these are still at an early
stage.

Adding further to the complexity is that the environment is already being shaped
by regulatory developments in the major jurisdictions, especially the US and
Europe. Australian entities that are active in those markets will need to meet
the clearing requirements that soon come into force there, and they will also
be affected indirectly to the extent that they deal with counterparties that
are subject to those jurisdictions.

In the United States, the Dodd-Frank regulations on OTC clearing are likely
to start taking effect around the second quarter of next year, and in Europe
the corresponding regulations under
EMIR[5] are likely to take effect by around 2013. Even before then, market behaviour,
and hence the environment for the Australian banks, will be influenced by the
anticipation of those requirements.

In broad outline, then, these are some of the key considerations that will need
to be taken into account in determining the way forward in Australia.

This brings me to my third question: where does the policy process in Australia
now stand?

In June, as you know, the Council of Financial
Regulators[6] released a discussion paper setting out these issues in detail and calling
for submissions from interested parties.

To help focus discussion, the Council paper put forward four propositions. In
summary, these were:

that in the absence of Australian regulatory action, domestic CCP solutions
may not emerge;

that where a market is of systemic importance to Australia, a move to offshore
central clearing might introduce risks to the Australian financial system
that do not currently exist;

that the Council agencies considered the market for Australian dollar interest
rate swaps to be systemically important within Australia; and

that in light of this, the Council agencies were considering the case for a
requirement that those instruments be centrally cleared, and as part of that
were considering whether such clearing should take place domestically.

I stress that these were not conclusions. They were preliminary propositions
that the Council agencies were seeking to test.

In response to the paper, we have received around 30 submissions, including
one from ISDA and a good number from ISDA members who are no doubt represented
here today, along with others from a range of other market participants and
interested parties. Most of the submissions are available on the Bank's
website. Council agencies have also engaged in a series of follow-up meetings
with those who made submissions. I've participated in a number of those
myself, and I've appreciated the spirit in which the industry has provided
its input.

If I've conveyed anything today, it's that these are difficult and complex
issues. Most of the submissions have stressed that point, and there was a strong
view from industry that it's important to take the time to get it right.[7]
We take the complexities seriously, and we need to continue engaging with industry
in the process of determining the best way forward.

That said, the Council's advice on these matters, when it's made, will
be determined by the public policy considerations of stability and efficiency
that I've just outlined. Not all industry participants will have the same
commercial interests and not all will be of the same view as to their preferred
outcome. But where the industry contributions will be valuable is in helping
to make clearer what are the costs and benefits, and the risks, of the alternative
approaches.

We hope to be in a position to put forward some conclusions from the consultation
process soon, but I can't foreshadow those today. In the meantime, I take
the opportunity to thank all those in the industry who have made constructive
contributions, and we look forward to continued engagement.